Setting money aside in an emergency fund is a good idea for everyone. If there is one certainty in life, it is uncertainty (except when it comes to death and taxes). Experts agree you need between three to six months of living expenses saved in cash to help you make ends meet in trying times like a job loss, or to pay for any big unexpected costs that arise. But there's less of a consensus on where the best place is to stow your vital fund.
Of course your emergency fund should in a safe place you can quickly access, not invested in the stock market. Many people keep their emergency savings in their checking account or savings account. Some buy a certificate of deposit (CD) from their banks. Both are safe places, but are they the best use of your money? Probably not. So where should you keep your precious emergency fund to get a nice return while keeping it safe?
Why you shouldn't keep your emergency fund in a bank account
For starters, the yield on a checking account is paltry. Plus, any interest you earn is fully taxable! That's right, Uncle Sam wants a piece of even the most minuscule interest earned, and the same goes for CDs. The interest on a CD should be higher than that offered by a checking account because the money is locked up for longer, but the interest is also fully taxable. Try calculating the after-tax yield on the estimated interest and you may be surprised by how little you keep after figuring in taxes.
Don't forget about inflation, either. Inflation happens when the prices of goods and services rise, and it's currently relatively low; the Bureau of Labor Statistics reported that prices rose about 1.9% over the past 12 months. But it's important to calculate the "real return," which is the interest earned minus the inflation rate. This tells us whether our money is keeping up with the increase in prices for goods and services. If the interest earned in a checking account is less than the inflation rate, then our cash won't be able to buy as much as it used to, so an emergency fund saved in a checking account actually becomes less valuable over time. Inflation is the invisible enemy of cash; you don't see it eroding your principal, but you feel it when you go to buy something.
CDs and checking accounts may be the path of least resistance for safeguarding a cash reserve thanks to their ease and convenience, but after taxes and inflation they earn no real interest, which isn't ideal. Luckily there are other options for saving your emergency fund that may be more compelling. Here are four to consider:
1. High-yield savings account
Banks require new capital to keep lending, and ultimately to make money. One way banks attract new savers is by marketing high-yield savings accounts. A high-yield savings account is like a traditional bank account in that both enjoy protection from the FDIC, Federal Deposit Insurance Corporation, of up to $250k per depositer per bank, in case the bank were to fold. Other similarities between high-yield savings accounts and traditional accounts is that the interest is taxable and they have high liquidity, meaning it's easy to get your money when you need it.
A high-yield savings account has a higher interest rate than checking accounts, mostly because they're usually only offered by online banks, so the institution has fewer expenses compared to traditional banks with physical locations. They pass these savings on to customers by paying them more to keep their money there.
Some high-yield savings accounts come with fees, minimum balances, or a required minimum length of investment, so it's best to shop around and compare terms. High-yield savings accounts are good for those who want to keep it simple and have their money readily available. If interest rates do go up, a high-yield savings account should increase their interest rates too, just like a traditional savings account but unlike a CD which has a fixed interest rate. Given that the interest earned in a high-yield savings account is taxable, people in a higher tax bracket may want to consider a more tax-advantaged savings method.
2. Money market funds
Typically offered in a brokerage account, a money market fund is another good place for your emergency fund. The interest is usually similar to that offered by a high-yield savings account and the funds are generally just as accessible -- though some offer limited check-writing privileges. For a full list of money and muni market funds within a brokerage account, ask the brokerage company where the account is held for the available options. Some money market funds may have higher minimums, too.
A money market invests in short-term instruments like CDs, short-term bonds and other fixed-income instruments. As interest rates rise, a money market will credit a higher rate, a key advantage over saving in a CD. However, a big difference between a money market and a CD is that funds you put in a money market are not FDIC insured. Instead, they are protected by Securities Investor Protection Corporation (SIPC) insurance, which provides investors with a safety net (usually up to $1 million) in case the brokerage holding their money market funds fails. Money markets are generally safe and conservative, but there is a small chance the account could "break the buck"; this means the principal amount dips below what you invested, but it is rare.
Money market funds are great for those who want the ability to invest a cash cushion if the opportunity arises. Since the money market is in a brokerage account, if an investor spots an opportunity or feels ready to invest some of their funds, they can simply move the money into the desired investment from the money market. This is different from a savings or checking account, where an investor must first transfer money from their bank to their brokerage account before buying a security, which can take several days.
There is a municipal money market for people in higher income tax brackets. Municipal money market funds are like standard money markets in how they work, but not in what they invest -- muni funds buy short-term municipal bonds, which are debt instruments issued by towns to finance projects like schools and highways.
The interest on muni market funds is exempt from federal taxes. However, the interest on muni funds is lower than that on money market funds, so it's best to know the "tax-equivalent yield," which is the interest before taxes. If the muni market fund's tax-equivalent yield or interest is greater than, say, a regular high-yield savings account or regular money market, it makes sense to use the muni fund. Generally, people in higher tax brackets are good fits for saving in the muni money market fund.
3. Treasury bills
A Treasury bill is a bond issued by the United States Treasury, and it can have a maturity ranging from 90 days to 30 years. The money is used to finance the expenses of the national government and when you buy a Treasury bill, you become a bondholder. You can buy Treasury bills through a brokerage account or directly through the U.S. Treasury's website.
Generally, any debt instrument issued by Treasury is a safe place to save money, since it is backed by the full faith and credit of the U.S. government. But it is still possible to lose money, if the bondholder sells the bond before it matures at a time when the bond is worth less than its face value.
For instance, all Treasury bonds, bills, and notes are issued at a discount, and if you buy a Treasury bond at $900 that matures in 20 years at $1,000, but instead of waiting for its maturity date, you cash it when the value is $990, then you've lost $10. For an emergency reserve it's best to stick to Treasury bills, which you hold for a shorter term of 30 or 60 days, so the funds are accessible if you should require the cash. Further, when the bill matures, you might buy a new bill with a higher interest rate, which you can't do with a fixed-rate CD.
The interest on short-term Treasuries is comparable to that of a high-yield savings account, but the big kicker is its tax benefit. Treasury bondholders don't pay state income taxes on the interest. Granted, state income taxes aren't much compared to federal, but something is better than nothing. Money you don't pay in taxes on interest is more money in your pocket, and with interest rates still low, every little bit helps.
4. Ultra-short term bonds
For those who are seeking higher yield than a savings account and are comfortable taking on more risk, look to ultra-short term bond exchange-traded funds (bond ETFs). This is probably the most risky of these options given that the underlying investments are corporate bonds that aren't guaranteed, but the trade-off is that the interest paid is usually the highest available.
The bonds within an ultra-short term fund generally mature in less than a year, so there is little interest rate risk (the chance that if interest rates go up, bond prices go down, or you lose your principal). There are several factors to look for in a short-duration bond ETF. Low expenses are important, given how fees eat into the yield. Good credit quality (meaning buying highly rated bonds, not junk) is a must, since this is your emergency fund. Good diversification across a number of holdings and types of bonds lowers your risk of loss. Finally, a solid track record is crucial, as newer ETFs may be unproven and could fail. All this information is usually listed on the website of the company that runs the bond ETF.
The advantages of a short-term bond ETFs include higher interest, moderate liquidity (you can sell and get your money within three days) and the ability to participate in higher interest rates (if interest rates rise, the ETF's manager can buy new bonds at a higher interest rate). The main disadvantage of a short-term bond ETF is the possibility of loss, as even high-quality bond ETFs can lose money at times.
A caveat for high earners: The interest on short-term bond ETFs is fully taxable, so those in higher tax brackets may want to check out a short-term municipal bond ETF instead.
There are many options to invest your emergency fund. The simplest and easiest is to use a checking account, but the interest is both minuscule and and taxable. A CD is a possibility, but that isn't always the best option given the amount of time one has to lock up the money and its taxable interest. Instead, consider keeping your cash cushion in a place that pays a higher interest and is more tax-efficient.